When it comes to analyzing companies, the way they manage their working capital is as important as how they manage the long term capital on the balance sheet. When we talk about working capital, it is loosely used to refer to the liquid assets that are critical to the company’s day to day operations. Working capital is basically a sign of whether the company is liquid enough to pay off its short term debts without impairing long term assets. Here are 10 things you must know about working capital of a company.
10 things to know about working capital of a company
1. The first thing is to understand the difference between gross working capital and net working capital. The gross working capital of a company refers to the current assets of a company while the net working capital of a company is the excess of current assets over current liabilities. A positive working capital is a good sign of corporate health whereas a negative working capital is not a good sign.
2. When we refer to current assets, the reference is to cash, marketable securities held for short term, accounts receivables and inventories. Current liabilities include short term loans taken, accounts payable, taxes outstanding etc. When you need to get a picture of the quick working capital, then inventory is excluded from the definition of current assets to give a clearer and more genuine picture.
3. Even if the company has a strong long term balance sheet and has managed to raise long term funds at low cost, the working capital must be a surplus as that is what impacts the operational efficiency of the company. Use of long term funds for working capital needs is a strict “No” since that makes your business highly vulnerable to the risk of maturity mismatch.
4. One of the popular measures of net working capital is the change in working capital. But this has to be taken with a pinch of sale. For example, one can increase the current assets by giving more liberal credit terms and increasing debtors. This will increase net working capital but will actually make your operational cycle more illiquid.
5. Working capital is also assessed on the basis of the current ratio and the quick ratio. The current ratio is calculated as (Current Assets / Current Liabilities). A current ratio of greater than 2 is considered to be healthy. A slight improvement is the quick ratio, which excludes inventories from current assets as they are not easily convertible into cash. The quick ratio gives a more reliable picture of liquidity.
6. Just as a low current ratio is not desirable, similarly a very high current ratio is also not desirable. It implies that the company is making inefficient use of its short term resources by locking it up in debtors and inventories. It could also mean that the company has the potential to give more liberal credit to its suppliers which could actually be a business accretive decision.
7. Working capital typically has a time frame of 1 year. It only calculates whether the company is liquid enough to pay its liabilities and commitments over the next one year. Hence, even longer term commitments that mature over the next 1 year are considered as part of the working capital cycle.
8. Is negative working capital OK. The answer is that it depends on the nature of the business. For example, the fast foods business or the retail business is a business where the inventory moves very fast and the credit period offered is almost zero. For example, in Japan they used to follow JIT (just in time) inventory management and the net working capital used to be negative in such cases.
9. If current assets can be financed easily through assured credit lines and at a very competitive cost of funding, then the actual working capital ratios may not be too relevant. Even if the current assets are insufficient, it would not really matter as easy lines of credit should take care of the same.
10. An important ratio here is the working capital turnover ratio (WCTR). It measures the ratio of the net sales to the working capital of the company and measures how efficiently the working capital is being cycled to generate sales. WCTR = (Net Sales / net working capital). The average working capital over the 1 year period is considered in this case. Normally, higher the WCTR it is considered to be a sign of operating efficiency and this works like any of the other turnover ratios.
For manufacturing companies, managing the working capital is a core function. How well the working capital manages the operations without hitches and at the most economical cost is what ultimately matters!